PART I CH-3

Introduction to Financial Management

Time Value of Money

Chapter

3
3-1

Time Value of Money

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Financial Management tools and techniques

Dr Pradip Kumar Sinha

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PART I CH-3

Introduction to Financial Management

Time Value of Money

Interest
Interest is a fee that is paid for having the use of money e.g., interest on mortgages for having the use of banks money. The compensation for waiting is the time value of money, called interest. Interest is usually paid in proportion and the period of time over which the money is used. The interest rate is typically stated as a percentage of the principal per period of time. Principal the amount of money that is lent or invested is called principal. Simple Interest that is paid solely on the amount of the principal is called simple interest. Simple interest is usually associated with loans or investments that are short-term in nature. The computatuion of simple interest is based on the following formula: Simple interest = principal interest rate per time period number of time period Cont. Copyright 2009, Dr Pradip Kumar Sinha
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PART I CH-3

Introduction to Financial Management

Time Value of Money

Compound Interest: Compound Interest occurs when interest earned

during the previous period itself earns interest in the next and subsequent
periods. Future Value of Re. 1

A sum of money invested today at compound interest accumulates to a

larger sum called the amount or future value.

The future value varies with the interest rate, the compounding frequency and the number of periods. If the future value of Re. 1 principal investment is known, we can use it to calculate the future value of any amount invested.

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PART I CH-3

Introduction to Financial Management

Time Value of Money

Compound Discount
Finding the present value of future receipts involves discounting the future value to the present. Discounting is the opposite of compounding. It involves finding the present value of some future amount of money that is assumed to include interest accumulations. Present Value of Re. 1

Knowing the present value of Re. 1 is useful because it enables us to find the
present value of any future payment.

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PART I CH-3

Introduction to Financial Management

Time Value of Money

Annuities
An annuity is a series of equal payments made at equal time intervals, with compounding or discounting taking place at the time of each payment.

Each annuity payment is called a rent.

There are several types of annuities, out of which in an ordinary annuity each rent is paid or received at the end of each period.

There are as many rents as there are periods. Installment purchases, longterm bonds, pension plans, and capital budgeting all involve annuities.

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PART I CH-3

Introduction to Financial Management

Time Value of Money

Future Value of Annuity of Re.1 The future value of an annuity or amount of annuity is the sum accumulated in the future from all the rents paid and the interest earned by the rents. The abbreviation FV is used for the future value of an annuity to differentiate it from the lower case fv used for the future value of Re.1. To obtain a table of future values of annuities, we assume payments of Re.1 each period made into a fund that earns 8 per cent interest compounded each period. The following diagram illustrates an annuity of four payments of Re.1, each paid at the end of each period, with interest of 8 per cent compounded each 8% interest per period period.
Re.1 P 1 2 Re.1 3 Time Periods 3-6 Financial Management tools and techniques Re.1 4 n Re.1 FV
Cont.

Copyright 2009, Dr Pradip Kumar Sinha

Dr Pradip Kumar Sinha

Excel Books

PART I CH-3

Introduction to Financial Management

Time Value of Money

Notice that there are four rents and four periods, each rent is paid at the end of each period. At the end of the first period, Re.1 is deposited and earns interest for three periods. The next rent earns interest for two periods, and so on. The amount at the end of the fourth period can be determined by calculating the future value of each individual Re.1 deposit as follows: Future value of Re. 1 at 8% for 3 periods Future value of Re. 1 at 8% for 2 periods Future value of Re. 1 at 8% for 1 period The fourth rent of Re. 1 earns no interest Total for 4 rents = = = = Rs. 1.25971 Rs. 1.16640 Rs. 1.08000 Re. 1.0000 Rs. 4.50611

The formula for the future value of an annuity of Re.1 can be used to produce tables for a variety of periods and interest rates
FV =

Fv =

(1+1)n 1 i

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PART I CH-3

Introduction to Financial Management

Time Value of Money

Present Value of Annuity of Re.1 The present value of an annuity is the sum that must be invested today at compound interest in order to obtain periodic rents over some future time. We use the abbreviation PV for the present value of an annuity. The present value of an ordinary annuity of Re.1 can be illustrated as follows:
Interest Re.1 PV 1 2 3 Time Periods
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Re.1 4

Re.1 n

Re.1

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PART I CH-3

Introduction to Financial Management

Time Value of Money

With each rent available at the end of each period, when compounding takes place, the number of rents is the same as the number of periods. By discounting each future event to the present, we find the present value of the entire annuity.

Present value of Re.1 discounted for 1 period at 8%

Present value of Re.1 discounted for 2 periods at 8% Present value of Re.1 discounted for 3 periods at 8% Present value of Re.1 discounted for 4 periods at 8% Present value of annuity of 4 rents at 8%

= Re. 0.92593
= 0.85734 = 0.79383 = 0.73503 Rs. 3.31213

The first rent is worth more than others because it is received earlier. Table on present value of annuities may be used to solve problems in this regard. The

formula used to construct the table is:

PV =

1 (1+i)n i
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PART I CH-3

Introduction to Financial Management

Time Value of Money

Present Value of an Infinite Life Annuity: Perpetuities An annuity that goes on for ever is called a perpetuity. The present value of a perpetuity of Rs. C amount is given by the simple formula: C/i where i is the rate of interest. As the length of time for which the annuity is received increases, the annuity discount factor increases but as length gets very long, this increase in the annuity factor slows down. In fact, as annuity life becomes infinitely long the annuity discount factor approaches an upper limit. Such a limit is 1/i.

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